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Hub You - Behavioural Finance: Focus on Intrinsic Value
Often in franchising, franchise outlets will have turnover of key personnel. They may seek the services of the franchisor to train the new employee. In some cases franchise or training of managers may actually be required to be done by the franchise himself. This is done to maintain consistency and quality control in the franchise outlets throughout the system.We noticed that in our franchising company this became a very serious issue. In this day and age where employees hold jobs for an average of 3.2 yrs. you can see the problem. In this new paradigm training becomes the key to success. It is for this reason that I added a clause into our franchising agreements below;4.3.3 New HiresIn the event that Franchisee hires a new location or operations manager or lead technician following completion of the initial training program described in Section 4.1.5, Franchisee will cause each of such new hires to attend a course providing the training required for such person’s position within ninety (90) calendar days of the date such person is hired by Franchisee or not later that the date such course is next offered by Franchisor if more than three months after such person is hired by Franchisee.--- --- --- --- --- ---It may be necessary for your company if you are in franchising to address this issue in your franchising agreements with your franchisees. It is therefore recommended that you contact an experienced franchising attorney and address this issue in advance of any potential eventuality or problem. I hope you will consider this in 2006.
If we are shifting our non-risk capital into high-risk investments, we are contradicting every rule of prudence to which the stock market ascribes and asking for further problems.
ISSUES
One of the most important issues in Behavioural Finance is whether the assumptions of investor rationality are realistic or not.
The concept can be explained with the help of an example. Let's assume that Mr. X invests and manages his portfolio in an efficient market. Here only seconds are available for a response to the news. There are a great number of factors that affect the decision of Mr. X. Further, these factors can affect each other. How can Mr. X draw the right judgements when the information is updated very frequently? Probably Mr. X works on a computer, through out the day, on which a utility function program is installed for his work. Every decision Mr. X is based on the calculation given by his computer. As soon as the portfolio is rebalanced, the computers utility function program analyses new alternatives. This process goes on and on over the course of the day. Obviously, Mr X does not show any joy, when he wins and no panic when he looses. Can a human brain behave like this? We know that a human brain can master only seven pieces of information at any one time.
So, how could one possibly absorb all the relevant information and process it correctly? People use simplifying heuristics (shortcuts) in order to control the complex
Simple fact: far not every first-time visitor will buy your product or subscribe to your services. Consider this: a very big percentage of people on the Internet are very picky comparison shoppers. They will go through every site they can find to get the “best deal”. The worst part of this is: once they leave your site chances are you won’t see them again.Now all your advertising dollars spent to get that visitors go down the drain. This is the last thing we want to happen. Can that be helped? Most certainly!!!The answer is in Opt-in list. What it does – it simply captures your visitors contact information and forwards it to you via e-mail or web form (keep checking my blog often for help with creating opt-ins). You can collect as much information about your visitors as you want and then integrate it into your marketing strategies to build a trusting, long-term relationship with your visitors, successfully turning them into RETURN BUYERS and DRAMATICALLY increasing your sales while SAVING big time on your advertising dollars. Once you captured your visitors’ information you DO NOT NEED to pay any more money for this same visitor eve again!With all the advantages of this marketing strategy you simply can’t afford to ignore this opportunity!How to collect e-mail addresses and build a MASSIVE subscribers list using opt-in The most common and universal way to collect your visitors’ e-mail addresses and other information is offering a free newsletter. Think about this: why do people go online? Mostly for two main reasons: check their e-mail and look for information. A free newsletter delivering industry news, solution to one or more of their problems, product updates would be an ideal opt-in offer. Another advantage of this method is – almost everyone can write a newsletter and it is suitable for practically every business type (with a few exceptions that I will cover in another post). You can go with either writing content for your n
The volume of research in the field of Behavioural Finance has grown over the recent years. The field merges the concepts of finance, economics and psychology to understand the human behaviour in the financial markets, to form winning investment strategies.
THE CONCEPT OF BEHAVIOURAL FINANCE
Behavioural finance is the study of the influence of psychology on the behaviour of financial practitioners and the subsequent effect on markets. Principal objective of an investment is to make money. We usually assume that investors always act in a manner that maximizes their return rationally. The Efficient Market Hypothesis (EMH), the central proposition of finance for the last thirty five years rests on assumption of rationality. But it has been proved that people are ruled as much by emotion as by cold logic and selfishness. While the emotions such as fear and greed often play an important role in poor decisions, there are other causes like cognitive biases, heuristics (shortcuts) that take investors to incorrectly analyse new information about a stock or currency and thus overreact or under react. Behavioural Finance is the study of how these mental errors and emotions can cause stocks or currency to be overvalued or undervalued, and to create investment strategies that gives a winning edge over the others investors.
I would like to bring out the behaviour pattern of a rational investor. This rational investor is assumed to act rationally in following ways:
o Makes decisions to maximize the expected utility.
o Fully informed with unbiased information.
o Absence of any distortion of judgement based on emotions.
It is to be kept in mind that risk resides not only in the price movements of dollars, gold, oil, commodities, companies and bonds. It also lurks inside us – in the way we misinterpret information, fool ourselves into thinking we know more than we do, and overreact to market swings. Information is useless if we misinterpret it or let emotions sway our judgement. Human beings are irrational about investing. Correct behaviour patterns are absolutely essential to successful investing - so to be financially successful one has to overcome these tendencies. if we can recognise these destructive urges, we can avoid them. Behavioural Finance combines the disciplines of economics and psychology specifically to study this phenomenon.
THE CONCEPT OF BUBBLES IN STOCK MARKET
A speculative bubble occurs when actions by market participants' results in stock prices to deviate from their fundamental valuation over a prolonged period of time. Speculative bubbles are difficult to explain by rational trading behaviour, and theories have been put forward to explain market psychology through behavioural finance1. They propose that when significant proportion of trading activity in the market is characterized by positive feedback behaviour, it may result in asset prices to shift away from their fundamental valuation. This price deviation encourages rational investors to trade in the same direction.
Speculative trades are based upon investors' private information held today, and are designed to provide investors with higher returns in the next period when that private information is fully revealed to the market. This implies a positive correlation in returns as market incorporate the information into prices. Trades due to portfolio rebalancing, or hedging, is not information based, and occurs when a trader may increase (or decrease) his stock holding by buying (or selling) a portion of his stock holding. This will be accomplished by increasing (or decreasing) the stock price to induce the opposite side of the trade.
FOCUS ON INTRINSIC VALUE
What are the implications for corporate managers? It is believed that such market deviations make it even more important for the executives of a company to understand the intrinsic value of its shares. This knowledge allows it to exploit any deviations, if and when they occur, to time the implementation of strategic decisions more successfully. Here are some examples of how corporate managers can take advantage of market deviations:
o Issuing additional share capital when the stock market attaches too high a value to the company's shares relative to their intrinsic value.
o Repurchasing shares when the market under-prices them relative to their intrinsic value.
o Paying for acquisitions with shares instead of cash when the market overprices them relative to their intrinsic value.
Two things must be kept in mind as regards this aspect of market deviations.
Firstly, these decisions must be grounded in a strong business strategy driven by the goal of creating shareholder value.
Secondly, managers should be cautious of analyses claiming to highlight market deviations. Furthermore, the deviations should be significant in both size and duration. Provided that a company's share price eventually returns to its intrinsic value in the long run, managers would benefit from using a discounted-cash-flow approach for strategic decisions.
It can thus be summarized that for strategic business decisions, the evidence strongly suggests that the market reflects intrinsic value.
INVESTING IRRATIONALITIES
Often turbulence in the market isn't linked to any perceivable event but to investor psychology. A fair amount of portfolio losses can be traced back to investor choices and reasons for making them. I would like to point out some of the ways by which investors unthinkingly inflict problems on themselves :
Herding
This is a cardinal sin in investing and this tendency to follow the crowd and depend on the direction of others is exactly how problems in the stock market arise. There are two actions that are caused by herd mentality:
o Panic buying
o Panic selling
Holding Out for a rare treat
Some investors, praying for a reversal for their stocks, hold onto them, other investors, settling for limited profit, sell stock that has great long-term potential. One of the big ironies of the investing world is that most investors are risk averse when chasing gains but become risk lovers when trying to avoid a loss.
If we are shifting our non-risk capital into high-risk investments, we are contradicting every rule of prudence to which the stock market ascribes and asking for further problems.
ISSUES
One of the most important issues in Behavioural Finance is whether the assumptions of investor rationality are realistic or not.
The concept can be explained with the help of an example. Let's assume that Mr. X invests and manages his portfolio in an efficient market. Here only seconds are available for a response to the news. There are a great number of factors that affect the decision of Mr. X. Further, these factors can affect each other. How can Mr. X draw the right judgements when the information is updated very frequently? Probably Mr. X works on a computer, through out the day, on which a utility function program is installed for his work. Every decision Mr. X is based on the calculation given by his computer. As soon as the portfolio is rebalanced, the computers utility function program analyses new alternatives. This process goes on and on over the course of the day. Obviously, Mr X does not show any joy, when he wins and no panic when he looses. Can a human brain behave like this? We know that a human brain can master only seven pieces of information at any one time.
So, how could one possibly absorb all the relevant information and process it correctly? People use simplifying heuristics (shortcuts) in order to control the complexi
EBay is a big market where you are able to sell almost all kinds of merchandises. You can go to eBay and browse through all the product categories to have an idea what are the products on sales. However, to sell merchandise on eBay, you will need to know about the characteristic of the product you intent to sell, in particular the product life cycle.If you intent to sell a fast moving consumer product such as digital camera, PC, handphones, etc, you will need to know about the product life cycle as these products evolve very fast. Typically, the product life cycle behavior as a normal distribution curve or a bell shape curve. It consists of four phases, namely the Launching Phase, Full-Retail Phase, End-of-Life Phase and Liquidation Phase.In the Launching Phase, this is the time where the product is just introduced into the market. It is new to the market where everybody is very interested about it and wants to get hold of it. As time goes by, the product will go into the Full-Retail Phase where you can find it selling everywhere and at the same price. During this phase, most of the people would have already purchased the product if they intent to have. And the purchased is usually done at retail shops. As times go further, the product will go into the End-of-Life Phase, where the sales and interest of the product start to decline. And finally, the product goes into the Liquidation Phase whereby the interest almost reduced to zero. Usually, at this final phase, a new product will be launched.So how does these information helps you on the product selection? As can be seen from the behavior, there are two phases during the product life cycle you can exploit. They are the Launching Phase and the Liquidation Phase. In the Launching Phase, this is the time where the interest in high where buyers are looking for something new and hope that they can get a good bargain from eBay. At times, due to the great interest, the buyers do not mind to pay a l
o Fully informed with unbiased information.
o Absence of any distortion of judgement based on emotions.
It is to be kept in mind that risk resides not only in the price movements of dollars, gold, oil, commodities, companies and bonds. It also lurks inside us – in the way we misinterpret information, fool ourselves into thinking we know more than we do, and overreact to market swings. Information is useless if we misinterpret it or let emotions sway our judgement. Human beings are irrational about investing. Correct behaviour patterns are absolutely essential to successful investing - so to be financially successful one has to overcome these tendencies. if we can recognise these destructive urges, we can avoid them. Behavioural Finance combines the disciplines of economics and psychology specifically to study this phenomenon.
THE CONCEPT OF BUBBLES IN STOCK MARKET
A speculative bubble occurs when actions by market participants' results in stock prices to deviate from their fundamental valuation over a prolonged period of time. Speculative bubbles are difficult to explain by rational trading behaviour, and theories have been put forward to explain market psychology through behavioural finance1. They propose that when significant proportion of trading activity in the market is characterized by positive feedback behaviour, it may result in asset prices to shift away from their fundamental valuation. This price deviation encourages rational investors to trade in the same direction.
Speculative trades are based upon investors' private information held today, and are designed to provide investors with higher returns in the next period when that private information is fully revealed to the market. This implies a positive correlation in returns as market incorporate the information into prices. Trades due to portfolio rebalancing, or hedging, is not information based, and occurs when a trader may increase (or decrease) his stock holding by buying (or selling) a portion of his stock holding. This will be accomplished by increasing (or decreasing) the stock price to induce the opposite side of the trade.
FOCUS ON INTRINSIC VALUE
What are the implications for corporate managers? It is believed that such market deviations make it even more important for the executives of a company to understand the intrinsic value of its shares. This knowledge allows it to exploit any deviations, if and when they occur, to time the implementation of strategic decisions more successfully. Here are some examples of how corporate managers can take advantage of market deviations:
o Issuing additional share capital when the stock market attaches too high a value to the company's shares relative to their intrinsic value.
o Repurchasing shares when the market under-prices them relative to their intrinsic value.
o Paying for acquisitions with shares instead of cash when the market overprices them relative to their intrinsic value.
Two things must be kept in mind as regards this aspect of market deviations.
Firstly, these decisions must be grounded in a strong business strategy driven by the goal of creating shareholder value.
Secondly, managers should be cautious of analyses claiming to highlight market deviations. Furthermore, the deviations should be significant in both size and duration. Provided that a company's share price eventually returns to its intrinsic value in the long run, managers would benefit from using a discounted-cash-flow approach for strategic decisions.
It can thus be summarized that for strategic business decisions, the evidence strongly suggests that the market reflects intrinsic value.
INVESTING IRRATIONALITIES
Often turbulence in the market isn't linked to any perceivable event but to investor psychology. A fair amount of portfolio losses can be traced back to investor choices and reasons for making them. I would like to point out some of the ways by which investors unthinkingly inflict problems on themselves :
Herding
This is a cardinal sin in investing and this tendency to follow the crowd and depend on the direction of others is exactly how problems in the stock market arise. There are two actions that are caused by herd mentality:
o Panic buying
o Panic selling
Holding Out for a rare treat
Some investors, praying for a reversal for their stocks, hold onto them, other investors, settling for limited profit, sell stock that has great long-term potential. One of the big ironies of the investing world is that most investors are risk averse when chasing gains but become risk lovers when trying to avoid a loss.
If we are shifting our non-risk capital into high-risk investments, we are contradicting every rule of prudence to which the stock market ascribes and asking for further problems.
ISSUES
One of the most important issues in Behavioural Finance is whether the assumptions of investor rationality are realistic or not.
The concept can be explained with the help of an example. Let's assume that Mr. X invests and manages his portfolio in an efficient market. Here only seconds are available for a response to the news. There are a great number of factors that affect the decision of Mr. X. Further, these factors can affect each other. How can Mr. X draw the right judgements when the information is updated very frequently? Probably Mr. X works on a computer, through out the day, on which a utility function program is installed for his work. Every decision Mr. X is based on the calculation given by his computer. As soon as the portfolio is rebalanced, the computers utility function program analyses new alternatives. This process goes on and on over the course of the day. Obviously, Mr X does not show any joy, when he wins and no panic when he looses. Can a human brain behave like this? We know that a human brain can master only seven pieces of information at any one time.
So, how could one possibly absorb all the relevant information and process it correctly? People use simplifying heuristics (shortcuts) in order to control the complex
Making money online is not a dream now. Making money online is not so easy but can be successfully completed with due care. There are various ways to make money online.Earning money online includes Website’s ad space, affiliate programs, MLM (Multi Level Marketing Programs), working as a freelancer, and last but not the least is creating and selling your own products.Reason behind why People are not making money online is that they do not have the knowledge or expertise to even get started.Website’s ad spaceWebsite’s ad space can be a very profitable way to make money online. For promoting and advertising of your product or service websites can be utilized. Web developer’s run their ads on their sites and earns a sufficient profit in exchange.Affiliate programsAffiliate programs simply mean you have to promote a product with a website. Affiliate programs provide you a product, training to show how to promote the product and other web promotion tools. you will earn a percentage of the sale. It’s not an easy job to find a good affiliate programs as there are countless affiliate programs online. Where can you find a good affiliate program? You have to search on internet to find a good affiliate program.MLM (Multi Level Marketing Programs)MLM (Multi Level Marketing Programs) is an excellent way to start earning money on-line right away. It’s a flexible way of earning money online. Basically it creates fairly large income by marketing and selling a product. Thousands earn their living in the multi-level marketing industry selling products as MLM is extremely popular.FreelancerFreelancing is simply offering your services to different employers on contract basis not on long term basis. Freelancing can be immensely enjoyable, satisfying, and lucrative field but there may be several drawbacks to freelancing as well.Creating and selling your own products.One of the most powerful ways for making mon
FOCUS ON INTRINSIC VALUE
What are the implications for corporate managers? It is believed that such market deviations make it even more important for the executives of a company to understand the intrinsic value of its shares. This knowledge allows it to exploit any deviations, if and when they occur, to time the implementation of strategic decisions more successfully. Here are some examples of how corporate managers can take advantage of market deviations:
o Issuing additional share capital when the stock market attaches too high a value to the company's shares relative to their intrinsic value.
o Repurchasing shares when the market under-prices them relative to their intrinsic value.
o Paying for acquisitions with shares instead of cash when the market overprices them relative to their intrinsic value.
Two things must be kept in mind as regards this aspect of market deviations.
Firstly, these decisions must be grounded in a strong business strategy driven by the goal of creating shareholder value.
Secondly, managers should be cautious of analyses claiming to highlight market deviations. Furthermore, the deviations should be significant in both size and duration. Provided that a company's share price eventually returns to its intrinsic value in the long run, managers would benefit from using a discounted-cash-flow approach for strategic decisions.
It can thus be summarized that for strategic business decisions, the evidence strongly suggests that the market reflects intrinsic value.
INVESTING IRRATIONALITIES
Often turbulence in the market isn't linked to any perceivable event but to investor psychology. A fair amount of portfolio losses can be traced back to investor choices and reasons for making them. I would like to point out some of the ways by which investors unthinkingly inflict problems on themselves :
Herding
This is a cardinal sin in investing and this tendency to follow the crowd and depend on the direction of others is exactly how problems in the stock market arise. There are two actions that are caused by herd mentality:
o Panic buying
o Panic selling
Holding Out for a rare treat
Some investors, praying for a reversal for their stocks, hold onto them, other investors, settling for limited profit, sell stock that has great long-term potential. One of the big ironies of the investing world is that most investors are risk averse when chasing gains but become risk lovers when trying to avoid a loss.
If we are shifting our non-risk capital into high-risk investments, we are contradicting every rule of prudence to which the stock market ascribes and asking for further problems.
ISSUES
One of the most important issues in Behavioural Finance is whether the assumptions of investor rationality are realistic or not.
The concept can be explained with the help of an example. Let's assume that Mr. X invests and manages his portfolio in an efficient market. Here only seconds are available for a response to the news. There are a great number of factors that affect the decision of Mr. X. Further, these factors can affect each other. How can Mr. X draw the right judgements when the information is updated very frequently? Probably Mr. X works on a computer, through out the day, on which a utility function program is installed for his work. Every decision Mr. X is based on the calculation given by his computer. As soon as the portfolio is rebalanced, the computers utility function program analyses new alternatives. This process goes on and on over the course of the day. Obviously, Mr X does not show any joy, when he wins and no panic when he looses. Can a human brain behave like this? We know that a human brain can master only seven pieces of information at any one time.
So, how could one possibly absorb all the relevant information and process it correctly? People use simplifying heuristics (shortcuts) in order to control the complex
They call it Guerrilla Marketing because you have to be fast on your feet, quick-witted, clever and creative. It's a way of thinking, a way of sizing up the marketplace and responding to a situation with great ideas and inspired tactics.Guerrilla Marketing means you don't have to have a huge advertising budget or hire a fancy high-priced ad agency or PR firm. And you don't have to wear camouflage and sneak up on the enemy -- the competition -- to disrupt or destroy their business.Forget the competition. Guerrilla Marketing is subversive and operates on a different level. The only enemy is your lack of imagination, your tendency to stick with the old, safe ways. Expensive ways.Guerrilla Marketing is defined as using unconventional ways of promoting your business on a very low budget -- or no budget, except your expenditure of time, creativity and energy. In other words, you do not need money, power or influence to succeed in business. Guerrilla Marketing is mainly used by the small business owner, although it is also used by multinational corporations.Here are two samples of G.M. techniques used with great success by small business entrepreneurs:PUBLICITY and PRESS RELEASES -- Many people are known to freak out at the thought of creating and sending off a press release to the media. Please do not freak out. The press release game is much easier than you would ever imagine, and many tools are available on the Internet to help you.For example, some PR and writing services on the Web offer templates for press releases, so you only have to fill in the blanks and send it off. Send it off to whom? And how? E-mail is the best way. Be sure to use your spell check. And be sure you are sending it to the right person at the right e-mail address. Again, Internet firms can guide you on this.An article in a magazine or newspaper is actually better than a paid ad. People still believe in the printed word. If it's in print
Firstly, these decisions must be grounded in a strong business strategy driven by the goal of creating shareholder value.
Secondly, managers should be cautious of analyses claiming to highlight market deviations. Furthermore, the deviations should be significant in both size and duration. Provided that a company's share price eventually returns to its intrinsic value in the long run, managers would benefit from using a discounted-cash-flow approach for strategic decisions.
It can thus be summarized that for strategic business decisions, the evidence strongly suggests that the market reflects intrinsic value.
INVESTING IRRATIONALITIES
Often turbulence in the market isn't linked to any perceivable event but to investor psychology. A fair amount of portfolio losses can be traced back to investor choices and reasons for making them. I would like to point out some of the ways by which investors unthinkingly inflict problems on themselves :
Herding
This is a cardinal sin in investing and this tendency to follow the crowd and depend on the direction of others is exactly how problems in the stock market arise. There are two actions that are caused by herd mentality:
o Panic buying
o Panic selling
Holding Out for a rare treat
Some investors, praying for a reversal for their stocks, hold onto them, other investors, settling for limited profit, sell stock that has great long-term potential. One of the big ironies of the investing world is that most investors are risk averse when chasing gains but become risk lovers when trying to avoid a loss.
If we are shifting our non-risk capital into high-risk investments, we are contradicting every rule of prudence to which the stock market ascribes and asking for further problems.
ISSUES
One of the most important issues in Behavioural Finance is whether the assumptions of investor rationality are realistic or not.
The concept can be explained with the help of an example. Let's assume that Mr. X invests and manages his portfolio in an efficient market. Here only seconds are available for a response to the news. There are a great number of factors that affect the decision of Mr. X. Further, these factors can affect each other. How can Mr. X draw the right judgements when the information is updated very frequently? Probably Mr. X works on a computer, through out the day, on which a utility function program is installed for his work. Every decision Mr. X is based on the calculation given by his computer. As soon as the portfolio is rebalanced, the computers utility function program analyses new alternatives. This process goes on and on over the course of the day. Obviously, Mr X does not show any joy, when he wins and no panic when he looses. Can a human brain behave like this? We know that a human brain can master only seven pieces of information at any one time.
So, how could one possibly absorb all the relevant information and process it correctly? People use simplifying heuristics (shortcuts) in order to control the complex
My subordinates are very experienced and older than me. How do I control them? Ramesh asked me. He was just 26 and working in a managerial position in a multinational company.Ramesh's problem is not isolated. Many times, young managers feel unhappy and embarrassed by elder subordinates. This results in total dissatisfaction of the employee and also bad work atmosphere. But you can avoid this by following the five principles given below.1. Be soft but firm.Elders often get irritated by a harsh tone from a young manager. But you can be conveying the same feelings in a calm cool voice. This will not hurt him. For example for a late coming person, the question "why are you late today?" can be put in many ways some of which hurting and some very gentle but firm.2. Try to understand their problems.Elders may have many problems which may seem irrelevant to you. This may include health related problems, family matters etc. A boss who understands them is more liked than a person who is indifferent to them and demands work without consideration.3. Value the experience.Many times the experience of an employee can be useful in handling situations. You as a manager can get their opinion about the problem at hand and try to improvise on the solution. Also discussions with elders valuing their opinions will be very much helpful to you in maintaining a relationship.4. Give them the pride by delegating.After some time you get a feel of the capabilities and limitations of each. If you find a subordinate capable you can make him feel important by delegating important work to him. Only thing is that he should not have a feeling that you are delegating because of your incapability.5. Keep your cool.In spite of all these, if you find that the situation is tense or unpleasant, try to keep your cool and handle it. It may even be better to leave it as it is for some time before you handle it. A gap may reduce the ten
If we are shifting our non-risk capital into high-risk investments, we are contradicting every rule of prudence to which the stock market ascribes and asking for further problems.
ISSUES
One of the most important issues in Behavioural Finance is whether the assumptions of investor rationality are realistic or not.
The concept can be explained with the help of an example. Let's assume that Mr. X invests and manages his portfolio in an efficient market. Here only seconds are available for a response to the news. There are a great number of factors that affect the decision of Mr. X. Further, these factors can affect each other. How can Mr. X draw the right judgements when the information is updated very frequently? Probably Mr. X works on a computer, through out the day, on which a utility function program is installed for his work. Every decision Mr. X is based on the calculation given by his computer. As soon as the portfolio is rebalanced, the computers utility function program analyses new alternatives. This process goes on and on over the course of the day. Obviously, Mr X does not show any joy, when he wins and no panic when he looses. Can a human brain behave like this? We know that a human brain can master only seven pieces of information at any one time.
So, how could one possibly absorb all the relevant information and process it correctly? People use simplifying heuristics (shortcuts) in order to control the complexity of information received. Psychological research has shown that the human brain often uses shortcuts to solve complex problems. These heuristics are rules or strategies for information processing, which help to find a quick, but not necessary optimal, solution. Once the information is simplified to manageable level, people use judgement heuristics. These shortcuts are needed to resolve the decision making as quickly as possible. Heuristics are also used to arrive at a quick judgement, they can, however, also systematically distort judgement in certain situations.
SIMPLIFICATION BIAS
The first step in reducing complexity is to simplify the decision. However it also adds the risk of arriving at a non-rational conclusion, unless one is careful.
MENTAL ACCOUNTING
People focus on one account (say purchase of share x) in particular when weighing things, relationship with other commitments or accounts (say purchase of share y) are usually ignored. I would like to explain this with the help of an illustration. For instance, Company A produces bathing costumes, and company B produces raincoats. Both companies are new, extremely efficient and innovating, so that purchasing shares in these companies would be a profitable proposition. A financial gain, however depends to a large extent on the whether in both cases, Company A will produce huge profits if the weather is fine, while Company B will make a loss, even though this is kept to a minimum, thanks to its efficient management. The situation is reversed in the case of bad weather. With mental accounting, either investment is risky when seen in isolation. But if we take into account the mutual effect of the uncertainty factor, i.e. the weather, then a combination of both shares become a lucrative, and at the same time secure investment.
AVAILABILITY CONSTRAINT
Not everybody has same degree of information. Some people prefer to see business news on CNBC TV 18, NDTV PROFIT. But others may like to see the serials on STAR PLUS. Obviously the first one may have more information, as compared to second.
REPRESENTATIVENESS
This is one of the mental shortcuts that make it hard for investors to correctly analyse new information. It helps the brain organise and quickly process large stock of data, but can cause investors to overreact to old information. For example, if a company is repeatedly giving losses, investors will become disillusioned with this past data, and thus may overreact to past information by ignoring valid signs of recovery. Thus, the stock of the company is undervalued because of this bias.
CHLALLENGES
Under the paradigm of traditional financial economics, decision makers are considered to be rational and utility maximizing. The assumption of rational expectations is simply an assumption - an assumption that could turn out not to be true.
Behavioural Finance has the potential to be a valuable supplement to the traditional financial theories in making investment decisions. The following fundamentals of behavioural finance give us a glimpse of the pitfalls to be avoided. These are the challenges which need to be overcome and addressed.
1. Hubris hypothesis: it is the tendency to be over optimistic. It results from psychological biases. The investor gets swayed by the momentum generated in the markets in recent past.
2. Sheep theory: it is a phenomenon where all the investors are running in the same direction. They follow the herd – not voluntarily, but to avoid being trampled.
3. Loss aversion: it says that investors take more risk when threatened with a loss. Thus mental penalty associated with a given loss is greater than the mental reward from a gain of the same size.
4. Anchoring: this causes investors to under react to new information. This can lead to investors to expect a company's earning to be in line with historical trends, leading to possible under reaction to trend changes.
5. Framing: this states that the way people behave depends on their way decision problems are framed. Even the same problem framed in different ways can cause people to make different choices.
6. Overconfidence: this is what leads people to think that they know more than they do. It leads investors to overestimate their predictive skills and believe they can time the market.
RELEVANCE TO INDIAN STOCK MARKETS
Behavioural finance holds definite clues and appears apt in the current IPO craze as regards Indian markets are concerned. The herd mentality is evident in the scramble for shares. As the positive information of excess subscriptions comes, more investors enter the bandwagon. When Prices of the stocks start soaring, everyone one is thinking of the same thing: I am going to sell on listing and book the profits. Can money making be so simple? Is life and the financial markets so predictable? One will see investors selling the stocks as soon as they get the allotments. Herd mentality will be at work with people trying to sell faster than the neighbour, thus eroding stock values at a faster rate. Greed thus becomes the graveyard. One needs to understand that there are no shortcuts to earning money. One has to work hard and have patience.
It is believed that perfect application of Behavioural finance can make an Indian investor successful, making fewer mistakes. Even if we learn to identify some common psychological and cognitive errors that plague even the wisest investment professional, it may be enough. To put it in Simple words, economic theory starts with a flawed basic premise that the investor is a rational being who will always act to maximise his financial gain. Yet, we are not rational beings, we are human beings.
In stock markets, behavioural finance can help explain situations such as why we hold on to stocks that are crashing, foolishly sell stocks that are rising, ridiculously overvalue stocks, jump in late and never find our right price to buy and sell stocks.
Let's take the example of the recent discovery of gas by Reliance industries. The stock starts spurting as everyone starts buying on this news. Newspapers start flashing
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